Despite uncertainty about trade, the U.S. economy is growing at around what most economists believe is its long-term potential growth rate, unemployment is very low, inflation remains subdued and financial markets are jumpy but at optimistic levels. So it’s reasonable to say that this week’s Federal Open Market Committee meeting is not the most critical in the Federal Reserve’s history. But it’s difficult to remember a meeting with more confusion.
Reflecting that confusion is a recent report from the New York Fed identifying a trillion-dollar uncertainty about the Fed’s future size. Is there any other entity on the planet that has a trillion-dollar question (that represents 4 percent of the entire U.S. economy) about its size in five years? FOMC members too have been all over the place: St. Louis Fed President James Bullard advocates a reduction in the central bank’s benchmark Fed Funds interest rate of 0.50 percent, while Boston Fed President Eric Rosengren wants to stand pat.
It would be one thing if the Fed consisted of inferior personnel. But Fed leaders’ credentials are exceptional — outstanding schools, advanced degrees and records of accomplishment.
So what accounts for the confusion?
If it’s not the people in the job, it could be the job description. The Fed is supposed to outguess the financial markets and predict U.S. and global economies, neither of which can be consistently accomplished, in order to bolster employment over which it has no effective control, moderate long-term interest rates, over which the Fed has no control, and stabilize inflation, over which it apparently has lost control.
Since 1995, despite Fed efforts to reach and exceed a “symmetrical” 2 percent target, its preferred measure of inflation, core personal consumption expenditure prices that exclude volatile food and energy has been stable within a range around its average of 1.7 percent. Movements around this average resemble a random walk.
What’s surprising is that stability around the average and the seeming randomness have occurred during a succession of extraordinary events — a housing boom, financial crisis, quantitative easing (QE) monetary stimulus amounting to 20 percent of GDP and trillion-dollar government deficits. Inflation exceeded 2 percent only for one extended period immediately before the Financial Crisis. (Doesn’t make it seem smart to go over 2 percent again does it?) Inflation plunged during the crisis but bounced right back after one of the most severe recessions in modern U.S. history.
While the movements of inflation appear random, it doesn’t mean they lack causality. During the same period since 1995 that inflation has been flat, its movements have been highly correlated with the foreign exchange value of the U.S. dollar, which explains most inflation fluctuations. While Fed policies affect the dollar’s value, international central bank policies and market sentiment, such as a recent flight to safety that has boosted the dollar’s value, also have major impact. From the standpoint of Fed monetary policy, these factors beyond the central bank’s control are effectively random.
The Fed does control short-term interest rates through its influence on the Federal Funds rate for interbank loans. Traditionally the Fed controlled this rate with its balance sheet, adding assets to lower rates and vice versa. Recently, under QE, the Fed has controlled Fed Funds by setting interest rates on its deposit facilities for banks, but Fed balance sheet size still influences rates. Real yields after inflation on U.S. Treasury T-bill short-term borrowings are negative when the Fed balance sheet is large, and the yields are higher with the normal small Fed balance sheet.
Only once since World War II has the Fed maintained a balance sheet comparable in size to its current plans, and that was during the war’s aftermath when it continued to operate under wartime procedures for supporting U.S. government borrowing.
In March 1951, the Fed negotiated its independence from Treasury in the Treasury-Fed accord. From that time until the recent financial crisis, the Fed’s balance sheet averaged 7.9 percent of GDP and real T-bill rates averaged 1.57 percent.
In the period after World War II inflation ended in 1949 and before the Treasury Fed Accord, the Fed’s balance sheet averaged 17.1 percent of GDP with real T-bill rates of -0.29 percent. Recently, during QE, the Fed’s balance sheet averaged 21.3 percent of GDP with -1.09 percent real T-bill yields.
Although sixty years apart, both periods of extended Fed balance sheets saw real yields suppressed by about 0.21 percent for every extra GDP point of Fed balance sheet size. Current Fed plans to carry a balance sheet above the 1951-2007 norm by about 10 percent of GDP suggest a real T-bill yield of about -0.40 percent, which, with 1.6 percent inflation, puts the actual yield at 1.20 percent, which is what the financial markets are expecting by next March.
Financial market expectations for future short-term interest rates around 1.20 percent are reflected in lower long-term bond yields. With the Fed holding current short-term rates around 2.00 percent, a yield curve inversion results, where long rates are lower than short rates despite increased long-term risk.
The Fed’s confusion is reflected in the yield curve inversion and in conflicting policies. On the one hand, it is carrying a large balance sheet that suppresses real interest rates; on the other hand, it seeks to raise interest rates by boosting inflation to a level it has not reached in 25 years without financial catastrophe.
The Fed can ease its confusion by following the market rather than trying to outguess it. Ultimately the Fed desires higher rates to provide latitude for rate cut stimulus in the event of a recession, and the market will take it there if it shrinks its balance sheet overhang.